Real Option

What Is A Real Option? 

A real option is a concept that grants companies the freedom to make business decisions and evaluate investment opportunities. These decisions typically revolve around initiating, delaying, terminating, or progressing with specific projects. Importantly, having the right to act on a project does not obligate the company to do so.

The term "real" in real options refers to investments involving tangible assets rather than financial instruments. These investments possess underlying assets that hold economic value but cannot be easily exchanged. Managers and top executives use quantitative and qualitative analysis to assess options and make informed decisions. By considering various factors, they evaluate each option's potential outcomes and benefits.

• The real options approach is the business's right to take up investment opportunities involving a large capital outlay where the companies have a right but no obligation.
• Companies mostly resort to five common decisions – option to expand, wait, contract switch, or abandon.
• After extensive qualitative and quantitative analysis, these decisions are made by considering factors like expected cash flows, economic situation, market conditions, risk elements, etc.
• Real options can be seen in mergers and acquisitions, joint ventures, new market entries, product developments, existing tangible assets, operations, etc.

Real Option Explained 

A real option gives companies rights, but no obligation to take up investment opportunities. Real options valuation (ROV) is a capital budgeting tool for companies. Companies take decisions related to tangible investments such as land, buildings, machinery, etc. Thus, financial and technical analysis differs from those used to evaluate instruments such as stocks and bonds. Also, these options are often compared with financial derivatives due to the underlying assets. However, the distinction lies in that the underlying assets in real options are not easily transferable. 

While assessing future projects, companies evaluate the payback period, the net present value, future cash flows, etc. For this, they use net present value (NPV) and discounted cash flow (DCF) methods to analyze the efficiency of projects. However, these methods only work in stable environments without much uncertainty.

Enter real options, a more comprehensive approach. ROV considers the present value of expected cash flows, unpredictability of expected cash flows, present value of fixed costs, the period of which opportunity is valid, the yield of riskless security, and the value lost over the duration of the option. However, experts suggest that companies follow an NPV/DCF analysis along with the ROV for a complete picture of the situation.

While there aren't any standard formulas or clear-cut procedures to quantitatively measure the ROV, businesses can resort to two alternatives. Firstly, methods used to quantify financial options can be extended to real options. Thus, the binomial model, Monte Carlo Simulation, and Black-Scholes model can be adopted. 

Secondly, as seen above, NPV/ DCF analysis can help quantify. Projects with a positive NPV are approved as they can recover the initial investment and recurring costs the company puts into them. Similarly, a positive ROV is preferred. Nevertheless, it depends on the quantifying method chosen, such as the Black-Scholes model.

Types 

Real options can be classified into five categories. Let's study them one by one.

1. Option to expand – The company decides to expand its business operations. It can include entering a new market, opening a new factory, or developing an innovative product for a market segment. This option is capital-intensive. The firm has to do a lot of research and do a cost-benefit analysis to decide if it should proceed with the option. This option is also referred to as a growth option.
2. Option to wait – While deciding to wait, the firm will delay any activities related to a particular project until conditions become favorable. Or, they might defer the decision-making process to a future date so that they can act on it with more information and resources. For instance, launching a new product during an economic recession might not be a good idea. Businesses also refer to this as a timing option or option to delay.
3. Option to contract – In this option, the business will decide to exit a project if conditions become unfavorable at some point. For example, an exporter selling goods to a war-torn country will decide beforehand to stop selling when situations escalate. 
4. Option to expand or contract – An option to switch refers to the situation where the company decides to shut down operations due to unfavorable conditions and resume them when the situation becomes favorable. Suppose a brand operating a luxury product will go for a switch option if an economy is in an impending recession.
5. Option to abandon – This is an extreme option where the business immediately shuts down a project. Reasons include incurring losses, negative NPV, or inability to operate. Also called an option to terminate, businesses seek to realize their salvage value by liquidating assets.  

This is an easier classification. Some sources suggest categorizing based on the project's size, lifetime, and operations; and further sub-classifying each. But the result is the same.

Examples 

Consider the following examples for clarity on the concept.

Example #1

Suppose Tech360 is a market leader in the technology industry. They were looking for an option to expand by acquiring a start-up named Intelligency, that offers virtual reality solutions. The management used discounted cash flow method and the real options valuation. After evaluating the project, they decided to acquire Intelligency.

Example #2

The Netherlands has followed the United States in imposing certain restrictions on the export of microchip technology, citing national security concerns. Semiconductor manufacturer, ASML Holding, is one of the many companies that will face restrictions. The news is a bad one for China. Chipmakers and exporters in the Netherlands will have an important decision to make. For them, these restrictions will mean an option to switch. They'll have to see how the situation turns out. If these restrictions continue, they must call for an option to abandon.

Advantages And Disadvantages

Now, let's see a comparative study of real options analysis:

#1 – Advantages

• Risk management is an important part of running a business. Especially while deciding to expand a business, there can be many factors that the company hadn't yet considered. Risk assessment is also equally important, like accounting for future cash flows, capital investment, market demographics, and economic situation. It is foundational to risk mitigation. ROV is an excellent risk management technique.
• Decision-making becomes easier with ROV. It addresses the questions related to the continuity of a project, its size, life, and operation. While a company has to research a lot when it is looking to expand, it also has to keep track of its existing projects. This will tell the business what action suits its survival and growth. 
• While real options confer rights to the company regarding tangible investments, they do not place an obligation. This is a double positive for the company as they can take advantage of their rights but not have their hands tied.
• Businesses actively use the NPV method to evaluate future projects. But ROV makes up for the defects of the NPV method by considering uncertainty related to a project. It is more comprehensive and works well in volatile and flexible markets.

#2 – Disadvantages

• While ROV is an excellent technique to gauge risk and support decision-making, its efficiency as a standalone method is questionable. According to an article published in Harvard Business Review, the unspoken assumption that ROV and DCF methods are mutually exclusive is false. Thus, DCF analysis and ROV together provide better clarity.
• The latter is not easily exchangeable like financial derivatives to which real options are mostly compared. Making a decision is easy, but executing it involves a lot of financial, structural, legal, and technical challenges. 
• ROV is associated with flexibility. Thus, it isn't specifically beneficial in stable and rigid environments. Here, NPV is a better approach.
• ROV requires sufficient information and a strong financial position to utilize opportunities. Lack of information can make the technique prone to errors, while sufficient funds are required for operating the project.

Frequently Asked Questions (FAQs)

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